Before you move into ROTH IRA

We have a tendency to take shortcuts. It is a psychologically proven design of most humans. But before saying I am converting to ROTH to take advantage of the current low capital gains rate (recommended by your trusted financial adviser) perform a long term analysis.

Tax planning

Should it be focused on highest possible return or optimal performance? The answer is personal preference. Some people only focus on getting the most money back, this is generally not the most effective financial planning or resource management. Others invest time to reach the balance between optimal earnings and taking advantage of all possible deductions. One tax professional reiterated: all good tax decisions are inevitably bad business decisions.

Cultivate your inner milli(onaire)

Is it possible that everyone has the opportunity to cultivate the habits necessary to become wealthy? 

Maybe. 

If you have the desire and the drive (I believe) you can become more financially secure than you may be now.  Here are four simple steps (when I say simple I mean straight forward not that they are easy to implement or introduce):

Start at the beginning:  Where do you want to be financially?  Start with easy goals, such as a savings account for a rainy day (i.e. three to six months of basic expenses saved up for an emergency).  You can also look at your current debts and prioritize the pay off by taking care of the most expensive credit lines (the ones with the highest interest rate), going down the list to the least expensive credit (such as mortgage or student debt, which are in most cases tax favorable).

Next: Review your income (all money you have coming in from work, hobbies, refunds, etc) and your monthly expenses (focus on the necessities and discretionary spending).  Take a look at our sister blog on NeizvestAcademy that pertains to the budget strategies.

Lastly: Use a retirement calculator, usually available online through your bank's website to estimate how much you'll need to save annually to reach your financial goal.

Now for the simple but not necessarily easy part: identify sources of savings or additional income to help yourself reach the financial security goals identified in the first three steps of this process.

ERM – Institutional Investment Trades & Portfolio Management Responsibilities

Boards of directors are charged with overseeing management’s implementation of various internal controls and policies.  But when it comes to large and complex institutions how can the boards be expected to notice all deficiencies? 

A moderate size community bank’s investment portfolio was liquidated to create additional liquidity to support its operating capital needs and to allow it to borrow less.  In this liquidation, the senior management initially just wanted to liquidate the securities at market or what’s worse at market established by just one broker.  In other words, just letting the broker who called to discuss rebalancing the portfolio provide that day’s bids and execute a multi million dollar trade.

You might say: So?!  The management knows what they are doing and the brokers will always give a fair bid!  This may be the correct assessment some times but not always (actually almost never.)

While a miniscule example, what’s $10 or $15 million to a multi million dollar institution you would say?  Well, it may mean a lot.  If the bank has not made money for the past 3 to 4 years a difference of $50 to $75 thousand may mean a lot to its bottom line. 

The better approach to such a trade would be:

First management should review the most recent security valuation report from the bank’s bond accounting provider.  This would provide an idea of the most recent market value for the bonds (by the way most banks can only hold bonds in their investment portfolios). 

Next management should assess if the bonds to be traded are used as collateral (some depositors require for their accounts to be secured by bond collateral to some degree) or are part of a repurchase agreement.  If so to find other bonds or find out what is necessary to notify the depositors or repurchase agreement administrators.

The following step, management should to determine the true market value of the bonds by either allowing a broker (or a few approved brokers) to list the bonds on the bond trading board (PIC), which would allow the “market” to bid on them.  In this move management would have to communicate the desired price to the broker so that when the bonds are listed the  open bids are close to target.

Alternatively, management could contact a few brokers and ask them to bid the bonds for their own portfolios.  In other words the bond would not get listed in the market.  Often the brokers will have other institutional clients looking for bonds in a specific market or by a specific issuer and will be able to provide bids that are competitive.

Once management get an idea of the minimum sell price they should create a report of the possible gain/loss for the full trade.  This report should be updated as the bonds sell.

Using this approach for a bond trade management will be organized and accountable for the trade.  Additionally the transaction becomes transparent (if reported correctly) to the board and other users of this information by clear documentation of the fact that management in no way forgone the interest of the bank or its shareholders.

But does this always happen?  What does your bank’s policy or procedures state about how such trades should be handled?

Resources:

OCC’s Bulletin 2002-19 Unsafe and Unsound Investment Portfolio Practices: http://www.occ.gov/news-issuances/bulletins/2002/bulletin-2002-19.html

Options Strategies: ILMN & AMZN

Here are some sample options strategies on two stocks, which show what happens under various types of options scenarios. The two underlying stocks are ILMN and AMZN. For this exercise, I pulled daily options quotes from CBOE.com http://www.cboe.com/DelayedQuote/QuoteTable.aspx

Before you consider playing with options be sure you know when they expire! Here is the 2012 expirations calendar: http://www.cboe.com/AboutCBOE/xcal2012.pdf

Basics: When you trade options contracts the standard contract size is 100 (options- calls or puts)

Strike price is the price on the face of the option.

Uncovered Option - A type of options contract that is not backed by an offsetting position that would help mitigate risk. “Trading naked”, as it is called, poses significant risks. However, an uncovered options contract can be profitable for the writer if the buyer cannot exercise the option because it is out of the money.

To translate this Jargon: uncovered or naked option is when you don’t own the stock or a commodity but you sold a call or a put contract. You can also be uncovered when you buy a put, which will give you the right to sell a stock or a commodity at a strike price, when it’s higher then the current price of the stock. Buying an uncovered put is not risky because you will almost always be able to buy the security at a lower price and will be able to resell it to the put writer at the strike price.

Out of the money options are those that have a strike price that is too high or too low making them worthless before they expire.

Here is an example of writing uncovered calls and puts:

 

Uncovered Calls and Puts
ILMN	Expiration in March		Max Risk Exposure
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Call @ $50	Put @ $50	Call @ $50	Put @ $50
On March 3/10/2012	0.6	0.35
Expired un-exercised Gain/ (Loss)	60	35
If called on the 16th	n/a	7
Gain/(Loss)	60	28	unlimited	4,965
AMZN	Expiration in March
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Call @ $180	Put @ $180	Call @ $180	Put @ $180
On March 3/10/2012	5.35	1.21
Expired un-exercised Gain/ (Loss)	535	121
If called on the 23rd	1,504	n/a
Gain/(Loss)	(969)	0	unlimited	17,879

You can see that because ILMN did not fluctuate before the expiration date the writer of the hypothetical call and the put earned 60 and 28 dollars respectively. Here is how it worked: It would not make sense for the holder of the call to exercise it because the strike price was $50, which is higher then $49.93 (the stock closed before the expiration date). On the other hand, the holder of the put contract could have exercised the put and made the writer buy the stock from them at $50. The assumption is that the writer would turn around and sell it at $49.93, thus losing $7 on 100 shares.

This table also shows the possible loss in the even the underlying stock went up. When it comes to calls the possible loss is really unlimited. On the other hand the loss on puts is limited to the multiple of the difference between the strike prices on the put and the close price of the stock before expiration.

Now in the example with AMZN you’ll see that the stock jumped from $184 to $195 in 12 days. Also, you’ll notice that due to this change the options did not expire on the “expiration calendar date” but continued to trade through the 23^rd. The writer of the call ended up loosing $969, because they had to sell the stock to the call holder at $180, while it was trading at $195. But because there was a profit from the original sale of call options was $535 the loss was not the full $1,500. Put expired unexercised because the strike price was lower then the close.

An uncovered bull call spread is constructed by buying a call option with a low exercise price, and selling another call option with a higher exercise price. Often the call with the lower exercise price will be at-the-money while the call with the higher exercise price is out-of-the-money. Both calls must have the same underlying security and expiration month.

Uncovered Bull Call Spread
ILMN	Expiration in March
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Buy Call @ $50	Sell Call @ $55
On March 3/10/2012	0.6	0.15
Expired un-exercised Gain/ (Loss)	(60)	15
If called on the 16th	n/a	n/a
Gain/(Loss)	(60)	15
Net Gain/(Loss)	(45)
AMZN	Expiration in March
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Buy Call @ $180	Sell Call @ $185
On March 3/10/2012	5.35	0
Expired un-exercised Gain/ (Loss)	(535)	225
If called on the 23rd	1,504	(1,004)
Gain/(Loss)	969	(779)
Net Gain/(Loss)	190

This is a strategy will work if the stock is expected to go up beyond the shorted (sold call option strike price). You see that because ILMN did not move very much the investor would have lost $45. They let the call contracts bought for $60 expire and the written call contracts sold for $15 expired unexercised.

An uncovered bull put spread is constructed by selling higher striking in-the-money put options and buying the same number of lower striking in-the-money put options on the same underlying security with the same expiration date. The options trader employing this strategy hopes that the price of the underlying security goes up far enough such that the written put options expire worthless.

Uncovered Bull Put Spread
ILMN	Expiration in March
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Sell Put @ $55	Buy Put @ $50
On March 3/10/2012	4.54	0.35
Expired un-exercised Gain/ (Loss)	454	(35)
If called on the 16th	n/a	7
Gain/(Loss)	454	(28)
Net Gain/(Loss)	426
AMZN	Expiration in March
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Sell Put @ $185	Buy Put @ $180
On March 3/10/2012	3.1	1.21
Expired un-exercised Gain/ (Loss)	310	(121)
If called on the 23rd	n/a	n/a
Gain/(Loss)	310	(121)
Net Gain/(Loss)	189

As you can see, this strategy worked well in both scenarios but was particularly successful for AMZN because of the drastic change in price. In other words the naked puts written went on unexercised and puts purchased cost less then the gain.

Uncovered Short Call Butterfly

A short butterfly position will make profit if the future volatility is higher than the implied volatility.

1.      Sell 1 ITM Call

2.      Buy 2 ATM Calls

3.      Sell 1 OTM Call

In The Money (ITM):

1.      For a call option, when the option's strike price is below the market price of the underlying asset.

2.      For a put option, when the strike price is above the market price of the underlying asset.

Uncovered Short Call Butterfly
ILMN	Expiration in April
Close on 3/10/2012	50.12
Close on 3/16/2012	49.93
	Sell Call @ $45	Buy 2 Calls @ $50	Sell Call @ $60
On March 3/10/2012	5.6	2.16	0.26
Expired un-exercised Gain (Loss)	560	(432)	26
If called on the 16th	(493)	14	n/a
Gain/(Loss)	67	(418)	26
Net Gain/(Loss)	(325)
AMZN	Expiration in April
Close on 3/10/2012	184.32
Close on 3/23/2012	195.04
	Sell Call @ $175	Buy 2 Calls @ $185	Sell Call @ $195
On March 3/10/2012	13.44	6.8	2.95
Expired un-exercised Gain (Loss)	1,344	(1,360)	295
If called on the 23rd	(2,004)	n/a	n/a
Gain/(Loss)	(660)	(1,360)	295
Net Gain/(Loss)	(2,020)

In this situation the combination worked against the investor in both scenarios. Max Profit = Net Premium Received - Commissions Paid. Max Profit is Achieved When Price of Underlying <= Strike Price of Lower Strike Short Call OR Price of Underlying >= Strike Price of Higher Strike Short Call.

Here are references used for this summary:

http://www.theoptionsguide.com/short-butterfly.aspx

http://en.wikipedia.org/wiki/Butterfly_(options)

http://www.investopedia.com/terms/i/inthemoney.asp